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Dombret: do not underestimate climate risks for the financial sector

Bundesbank Executive Board member Andreas Dombret has warned of the effects of climate change. "Climate change affects each and everything. Our standards of living. Migration flows. Technological developments. The economy," he said in a speech delivered at the National University of Singapore. He emphasised in particular the stability risks for the financial sector, stating that credit institutions are being increasingly affected by the rising costs resulting from extreme weather events. Floods and storms could thus result in significant losses for both the public and the private sector. Hurricane Harvey, which recently swept across the United States, may have caused up to 180 billion dollars' worth of damage. Other events, such as droughts, could have a devastating impact on crop yields and therefore impair the productivity of the agricultural sector, Mr Dombret remarked. Households would be more likely to default on their loans and mortgages, while the collateral they had provided would no longer be available to cover these losses. "If losses are insured, the insurance sector is exposed. If losses are uninsured, banks and other financial institutions are exposed," he added.

Sinking profits and the depreciation of affected enterprises would also result in increased credit risks for banks. Extreme weather events could also disrupt supply chains, for example, thereby impairing productivity. Reduced productivity would then erode the value of investments held by financial institutions in an affected region. "Average weather-related losses per year worldwide have roughly tripled over the past 30 years," according to Mr Dombret, who referenced a study conducted by the Bank of England. "If, as expected, extreme climate events become more frequent, the number of uninsurable risks will increase." Such risks would subsequently present a danger to financial stability.

Climate policy surrounded by uncertainty

Mr Dombret also addressed the risks that transitioning to a new climate policy would pose to the financial sector. To achieve the Paris Climate Agreement goal of keeping the increase in the global average temperature to below two degrees with a probability of 50 per cent, the maximum amount of carbon emissions this century must remain below 1,100 gigatonnes of carbon dioxide. The total amount of carbon embedded in all known global fossil fuel reserves is currently estimated at roughly 2,800 gigatonnes. "This means that, to reach the 2-degree target with a reasonably high probability, about two-thirds of all known coal, oil and gas reserves must remain in the ground," Mr Dombret said, adding that many companies are basing a significant share of their value on the future exploitation of precisely these reserves, however. According to the World Wide Fund for Nature, listed fossil fuel companies currently carry more than half of the total global fossil fuel reserves on their balance sheets as assets. "If these reserves cannot be developed, they become worthless – they become 'stranded assets', and the value of the enterprise declines to the same extent," Mr Dombret warned.

Such a development would not be confined to companies operating in the production of fossil fuels or in the energy sector, according to Mr Dombret, and other sectors dependent on fossil fuels, such as transportation, logistics, automotive, chemicals and heavy industry, could be affected as well. Moreover, this in turn would have an impact on the financial sector due to the fact that financial institutions have direct investments in these industries. Furthermore, insurers, pension funds and other investors are tending to align their portfolios with capital market indices, which often contain large portions of the industries that might be affected by the transition.

Strengthen the role of supervisors

Mr Dombret warned against understating the risks posed by climate change and highlighted the role played by central banks. The Bundesbank and other central banks are in the process of improving their analytical capacities with regard to climate risks, he added. As supervisors who are in close contact with financial institutions, central banks should foster an awareness of physical and transition risks and ensure that these are taken seriously. "Many banks and institutional investors have yet to develop the capacity to identify and quantify the risks that arise when environmental aspects are factored into the valuation of their assets," Mr Dombret claimed, adding that the risks to financial institutions arising from climate change should also, where appropriate, be incorporated into the supervisory risk analyses.